Creating a college fund for children or grandchildren is a common financial goal among physicians. With a 529 plan, you can build up a nest egg for tuition, while also taking advantage of a variety of tax perks.
A 529 plan is a tax-advantaged account designated to save for education costs. Also known as “qualified tuition plans,” 529 plans can be used to pay for an array of qualified education expenses. These plans are sponsored by states, state agencies, or educational institutions.
529 plans don’t place limits on income, age, or yearly contributions, and the account holder retains control of the 529 even when the beneficiary reaches the legal age of adulthood.
To effectively use a 529 plan for education planning, follow these guidelines:
Let’s explore each step in-depth to learn how to make the most of your education planning:
- Research all potential tax credits or deductions
- Pick and fund a 529 plan
- Plan strategically to avoid penalties
Research all potential tax credits or deductions
Qualified distributions from 529 plans are not
federally taxed. While contributions to 529 plans are not
federally deductible, most states offer some form of 529 tax credit or deduction. The exact tax treatment of 529 plans will vary from state to state.
Almost every state offers their own 529 plan, and some states, such as Colorado, offer multiple plans. Many states offer a tax benefit for contributing to an in-state 529 plan. However, a few states (Arizona, Kansas, Missouri, Montana, Pennsylvania) offer tax benefits for contributing to any state’s 529 plan.
Too often, taxpayers do not even realize that their 529 contributions qualify them to receive a tax credit or deduction from their state. Make sure you thoroughly explore all potential tax-advantages in your state as you consider different plans.
You can purchase 529 plans either direct-sold from a state or through a financial advisor. When selecting a 529 plan, there are several major questions to consider:
Which state’s 529 plan will you choose?
Contrary to popular belief, you do not have to purchase the 529 plan offered by the state in which you pay taxes, nor the state in which the beneficiary will attend school. In other words, you could live and pay taxes in Arkansas and buy a 529 plan from Colorado in order to pay for your child’s college tuition in New York.
As previously discussed, there are often tax benefits to investing in your own state’s 529 plan. If, however, you live in a state that does not offer tax perks for contributions to an in-state plan, then you should shop around and find the best option for your needs. Different state plans vary regarding contribution minimums and maximums as wells options for rolling over 529 funds.
Will you select a college savings plan or a prepaid plan?
The most common type of 529 is a 529 college savings plan, which allows investors to save and grow tax-free funds. These funds can later be withdrawn tax-free for qualified education expenses at any approved post-secondary institution.
You can also select a 529 prepaid plan, which allows investors to pre-pay in-state public tuition, either partially or in full. 529 prepaid plans are far less common, because the beneficiary must attend an in-state public institution. However, if you are certain that the beneficiary will attend a qualifying in-state institution, a prepaid 529 plan allows you to lock in the tuition rate at the time of prepayment. There are twelve states that offer prepaid plans.
What assets will you choose for your 529 plan?
There are a variety of options for investing funds within a 529 plan. You can choose between a wide array of different assets to suit your risk tolerance, investing timeline, and growth goals.
One common choice for 529s are age-based investments, which are tailored to a target-date, such as your child’s first year of college. Age-based investments automatically adjust their asset allocation to become more conservative as the target date nears. Another option, target-risk portfolios, adjust the investment allocation to match an aggressive growth goal. Finally, more individualized portfolios may consist of underlying investments that mirror any number of available index funds.
Whether you prefer a “set it and forget it” approach or highly customized, active management, 529 plans offer a vast range of investment choices. A personal financial advisor can help you explore and weigh different options for your 529 plans.
Plan strategically to avoid penalties
When it comes time to distribute funds from a 529 plan, it’s important to carefully plan both when
you will withdraw.
First, make sure your distributions occur in the same tax year as the payment for the qualifying education expenses. If your distributions are spread out over different school semesters, make sure you are only claiming expenses within the tax year of the distribution.
In addition, your withdrawals should match the cost of qualifying expenses. You can either make payments directly from your 529 account to an educational institution, or you can transfer money from your 529 account to a bank to reimburse yourself for qualifying expenses. Direct payment from a 529 account is often easier for record-keeping and ensures your withdrawal amounts match your qualifying payments. However, if you want to use 529 funds to pay for various smaller expenses, such as textbooks, it may be easier to pay with funds from a bank account. To make sure that your distributions align with your payments, it is critical to know what constitutes a qualified expense.
529 savings plans can be used for far more than just college tuition. Each year, a beneficiary can receive up to $10,000 for qualifying expenses, including:
Non-qualifying costs include transportation and travel costs, insurance costs, personal electronics, and club dues. Keep in mind that additional financial aid or tax incentives can complicate your calculations. After totalling up the qualifying costs above, subtract the value of any Pell Grants, tax-free scholarships, tax-free employer assistance, Lifetime Learning Credits, or American Opportunity Tax Credits.
If you find yourself with extra money leftover in a 529 account, you can assign a new beneficiary with no penalty. However, if you must withdraw money from a 529 plan for non-qualified expenses, you will pay a 10% penalty and be subject to pay income tax on said expenses. One exception: if the beneficiary receives a scholarship, you can make a non-qualified withdrawal up to the scholarship amount penalty-free. Careful planning and detailed record keeping are essential to avoid costly penalties and reap the maximum tax benefit from your 529 plan.
- Tuition costs for an elementary, middle, high school or post-secondary institution.
- Cost of room and board (limited to the actual amount charged for on-campus living OR federal financial aid estimations)
- Required books and supplies
- Computers and related equipment for educational purposes
- Student Loan Repayment
For doctors who plan to save up for education costs, a 529 plan is a low-maintenance, effective investment that offers a variety of tax perks. Talk with a financial advisor to determine the right 529 plan and funding approach to lay the groundwork for your loved ones’ futures.